ECONOMIC SURVEY: The Festering Twin Balance Sheet Problem

ECONOMIC SURVEY 2017 CHAPTERWISE ANALYSIS

The Festering Twin Balance Sheet Problem

“The most costly outlay is time.”– Antiphon the SophistAthens, 5th Century BCE

For some time, India has been trying to solve its Twin Balance Sheet problem–overleveraged companies and bad-loan-encumbered banks — using a decentralised approach, under which banks have been put in charge of the restructuring decisions. But decisive resolutions of the loans, concentrated in the large companies, have eluded successive attempts at reform. The problem has consequently continued to fester: NPAs keep growing, while credit and investment keep falling. Perhaps it is time to consider a different approach – a centralised Public Sector Asset Rehabilitation Agency that could take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.

Introduction: Rising NPAs on account of AQR

In February 2016, financial markets in India were rocked by bad news from the banking system. Banks reported that nonperforming assets had soared. Normally, nonperforming assets (NPAs) soar when there is an economic crisis, triggering widespread bankruptcies.. But there was no economic crisis in India; The RBI had conducted an Asset Quality Review (AQR), following which banks cleaned up their books. Equally striking was the concentration of these bad loans.

More than four-fifths of the non-performing assets were in the public sector banks, where the NPA ratio had reached almost 12 percent.

Corporate Troubles: ICR below 1

Around 40 percent of the corporate debt it monitored was owed by companies which had an interest coverage ratio less than 1, meaning they did not earn enough to pay the interest obligations on their loans.

It became clear that India was suffering from a “twin balance sheet problem” – where both the banking and corporate sectors were under stress.

How can this possibly be explained?

Their corporations over-expand during a boom, leaving them with obligations that they can’t repay. So, they default on their debts, leaving bank balance sheets impaired, as well.

What makes India’s case unique?

This model, however, doesn’t seem to fit India’s case. because Indian companies and banks had avoided the boom period mistakes made by their counterparts abroad. They were prevented from accumulating too much leverage, because prudential restrictions kept bank credit from expanding excessively during the boom, while capital controls prevented an undue recourse to foreign loans.hand.

In other TBS cases, growth was derailed because high NPA levels had triggered banking crises.

But this has not happened in India. And all for a very good reason: because the bulk of the problem has been concentrated in the public sector banks, which not only hold their own capital but are ultimately backed by the government, As a result, creditors have retained complete confidence in the banking system.

What went wrong?

The origins of the NPA problem lie not in the events of the past few years, but much further back in time, in decisions taken during the mid-2000s. During that period, economies all over the world were booming, almost no country more than India, where GDP growth had surged to 9-10 percent per annum.

To gain from growth firms started increasing production by hiring labour aggressively, which in turn sent wages soaring. This investment was financed by an astonishing credit boom. There were also large inflows of funding from overseas. All of this added up to an extraordinary increase in the debt.

But just as companies were taking on more risk, things started to go wrong.

Costs soared far above budgeted levels, as securing land and environmental clearances proved much more difficult and time consuming than expected.

At the same time, forecast revenues collapsed after the GFC.

As if these problems were not enough, financing costs increased sharply.

And firms that had borrowed abroad when the rupee was trading around Rs 40/dollar were hit hard when the rupee depreciated.

What Explains the Twin Balance Sheet Syndrome with Indian Characteristics?

India did indeed follow the standard path to the TBS problem: a surge of borrowing, leading to overleverage and debt servicing problems.

What distinguished India from other countries was the consequence of TBS. TBS did not lead to economic stagnation. The most important difference between India and other countries, however, was the way in which the financial system responded to the intense stress on corporations. In other countries, creditors would have triggered bankruptcies. But in India this did not occur. Instead, the strategy was to allow time for the corporate wounds to heal.

Banks also extended fresh funding to the stressed firms to tide them over until demand recovered.

Is the Strategy Sustainable?

This strategy can indeed be sustainable. But for this to occur one of two scenarios would need to materialise.

Under the “phoenix” scenario, accelerating growth would gradually raise the cash flows of stressed companies, eventually allowing them to service their debts.

Under the “containment” scenario, the NPAs would merely need to be limited in nominal terms. Once this is done, they would swiftly shrink as a share of the economy and a proportion of bank balance sheets.

The Infection spreads to MSMEs:

For much of the period since the Global Financial Crisis, the problems were concentrated in the large companies. Starting in the second half of 2016, however, a significant proportion of the increases in NPAs – four-fifths of the slippages during the second quarter – came from mid-size and MSMEs.

The Curious Case of Power & Telecom Sector:

POWER SECTOR – The situation in the power sector illustrates the more general problem. There have been cost overruns at the new private power plants. Plant load factors (PLF, actual electricity production as a share of capacity) are exceptionally low. Meanwhile, merchant tariffs for electricity purchased in the spot market have slid far below the breakeven rate.

TELECOM SECTOR – Stress has also expanded to the telecom sector, where interest coverage ratios have deteriorated as new entry has increased competition, prompting a major round of price-cutting. In short, stress on the corporate sector is not only deepening; it is also widening.

How the PSBs responded:

Public sector banks have responded to their difficult financial situation in the standard way. They have tried to protect their capital positions by minimizing the new risks they are taking, that is by scaling back their new lending. As a result, total credit to the corporate sector has been decelerating steadily. In real terms, such credit growth is now negative.

Public sector banks have also responded to their stress in another standard way. They have tried to compensate for the lack of earnings from the non-performing part of their portfolio by widening their interest margins. The increase in margins means that performing borrowers and depositors are effectively being taxed in order to subsidise the non-performing borrowers. But if this trend of disintermediation continues, it will leave much of the “tax” burden on the MSMEs.

What needs to be done?

The RBI has over the past few years introduced a number of mechanisms to deal with the stressed asset problem. Initially, the schemes focused on rescheduling amortisations. RBI deployed mechanisms to deal with solvency issues, as well.

RBI has been encouraging the establishment of private Asset Reconstruction Companies (ARCs), in the hope that they would buy up the bad loans of the commercial banks.This strategy, however, has had only limited success. The problem is that ARCs have found it difficult to recover much from the debtors.

So the RBI has focussed more recently on two other, bank-based workout mechanisms. In June 2015, the Strategic Debt Restructuring (SDR) scheme was introduced, under which creditors could take over firms that were unable to pay and sell them to new owners. The following year, the Sustainable Structuring of Stressed Assets (S4A) was announced, under which creditors could provide firms with debt reductions up to 50 percent in order to restore their financial viability. Their success, however, has been limited.

CASE FOR PARA:

One possible strategy would be to create a ‘Public Sector Asset Rehabilitation Agency’ (PARA), charged with working out the largest and most complex cases. It could solve the coordination problem, since debts would be centralised in one agency.

It would purchase specified loans (for example, those belonging to large, over-indebted infrastructure and steel firms) from banks and then work them out, either by converting debt to equity and selling the stakes in auctions or by granting debt reduction, depending on professional assessments of the value-maximizing strategy.

Once the loans are off the books of the public sector banks, the government would recapitalise them, thereby restoring them to financial health and allowing them to shift their resources – financial and human – back toward the critical task of making new loans.

Of course, all of this will come at a price. the bulk of the burden will necessarily fall on the government. That said, the capital requirements would nonetheless be large. Part would need tocome from government issues of securities. A second source of funding could be the capital markets. A third source of capital could be the RBI. The RBI would (in effect) transfer some of the government securities it is currently holding to public sector banks and PARA.

The chapter ends with discussion on four of the key measures proposed by the Economic Survey 2015-16 in addressing the stressed assets problem i.e. 4 R’s: Reform, Recognition, Recapitalization, and Resolution.

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